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Why Cash Flow Is More Important Than Profit

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Why Cash Flow Is More Important Than Profit PUBLICATION OF THE NEBRASKA BUSINESS DEVELOPMENT CENTER Why cash flow is more important than profit It is quite possible for a company to report profits but go out of business. It is also possible for a company to be profitable and not be able to grow, secure financing or attract investors. any equate the success of a company to its eventually go out of commission. Either way, “Cash is reported profits. While profits are good, they King” in keeping a business alive. Mdo no adequately represent the financial standing of a firm. It is quite possible for a company to report profits but go out of business. It is also pos- Cover the gap between sible for a company to be profitable and not be able to receivables and payables grow, secure financing, or attract investors. There are a Another important consideration is that profit reports couple of reasons why cash flows are a better indicator are based on sales income. The main issue here is that of a company’s financial health. the recorded revenue is often greater than the amount of actual cash received from sales. When sales are on Cash is King credit, the collection period on accounts receivable can last 2-3 Profit figures are easier to manipulate because they months. This means that the include non-cash line items such as depreciation ex- company needs to have enough penses or goodwill write-offs. Under generally accepted cash on hand to float its opera- accounting principles (GAAP) businesses can use non- tions for the duration of the col- cash expenses such as depreciation and amortization lection period. to offset large capital expenditures. Using the previous examples, Cash flow statements, on the other hand, provide this means having the cash equivalent of 2-3 months’ a more straightforward report of the cash available. worth of operating expenses and inventory purchases In other words, a company can appear profitable “on on hand. In the likely event that a firm also makes paper” but not have enough actual cash to replenish its purchases on credit, accounts payable become another inventory or pay its immediate operating expenses such important factor to consider. To be sustainable, a busi- as lease and utilities. ness has to pay special attention to its cash cycle and If a company cannot purchase new inventory, it will make sure to cover the cash gap between receivables slowly become unable to generate new sales. If a and payables. company cannot afford its operating expenses, it will nbdc.unomaha.edu 1 PUBLICATION OF THE NEBRASKA BUSINESS DEVELOPMENT CENTER If the business goes out of cash, operations will sim- increased capacity can come in the form of additional ply cease. This further illustrates why cash flows provide personnel, equipment, new locations, more inventory, a better sense of the financial situation of a business. etc. Either way, the company has to be able to remain in operation until its cash flows stabilize and become posi- Why lenders look at cash flow tive. Assuming that a firm has enough cash to maintain Business owners may think that securing commercial its current level of op- financing will solve the growth dilemma. It is not that sim- eration, most business ple. Lenders expect regular repayments on the financ- Companies should owners want to grow their ing they provide. As such, lenders rely on a company’s prepare for cash company. If cash is king current and projected cash flows to determine whether it will be able to afford the additional debt. outlays to considerably in sustaining ongoing business operations, it exceed cash inflows Overall, understanding a company’s cash situation becomes that much more is crucial to making sound business decisions. Owners during the early stages vital when considering must strive to understand and always be in-touch with of expansion. expansion. Sales growth the cash aspect of their enterprise, regardless of the is great… unless it results profits reported. Fortunately, business owners do not in the total depletion of have to do it alone. They can work with their bookkeeper cash. Companies should or accountant to review how cash circulates through prepare for cash outlays to considerably exceed cash their business. They can also take advantage of the inflows during the early stages of expansion. In fact, to Small Business Development Centers available to small be able to generate a growth in sales, businesses must businesses and aspiring entrepreneurs throughout the first be able to afford an expansion in capacity. This United States and its territories. SOURCES Fulmer, J. G., Jr., Finch, J. H., Smythe, T. I., Jr., & Payne, T. H. (2002). Growing sales and losing cash: Assisting your small-business cus- tomer with cash flow management. Commercial Lending Review, 17(4), 14-19. Glassman, J. K. (2012). Go With the Cash Flow. Kiplinger’s Personal Finance, 66(8), 16-18. Osgood, W. R. (2004). Common Sense Cash Flow Management. Strategic Management Learning System Workbook 1. Knowledge Institute, Inc. nbdc.unomaha.edu 2 PUBLICATION OF THE NEBRASKA BUSINESS DEVELOPMENT CENTER About the author Aretha Boex is the Omaha center director of the Nebraska Business Development Center. She man- ages the small business consulting program and leads a team of professionals who provide direct technical assistance to owners and potential owners of small businesses. She brings extensive experience in man- agement consulting, business planning, financial analy- sis and small business loan applications. Aretha is a Certified Economic Development Finance Professional through the National Development Council. She holds a Master of Business Administration and a Master of Science in Management Information Systems from the University of Nebraska at Omaha. About the Nebraska Business Development Center NBDC is a cooperative program of the U.S. Small Business Administration (SBA) and the College of Business Administration at the University of Nebraska at Omaha (UNO). NBDC partners with the University of Nebraska at Kearney, Southeast Com- munity College, Wayne State College, Mid-Plains Community College and Chadron State College to provide consulting and business support services from offices in Omaha, Lincoln, Kearney, Grand Island, North Platte, Wayne, Auburn, Scottsbluff and Chadron. Learn more about NBDC at nbdc.unomaha.edu © 2015 Nebraska Business Development Center Permission is given for reproduction of this whitepaper in whole or in part, provided that the copyright notice is preserved and that the author and the Nebraska Business Development Center are acknowledged nbdc.unomaha.edu 3 .
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